Say It Ain’t So!

Dave SchulerDecember 20, 2010

It seems like only yesterday that Arthur Andersen, then the largest accounting firm in the world, was found guilty of colluding with its client, Enron, in the latter’s falsification of its financial statements which Andersen, as the company’s auditor, was legally and ethically required to reveal. Now Ernst & Young, Lehman Bros. auditor, is facing civil action for its role in Lehman’s collapse:

New York prosecutors are poised to file civil fraud charges against Ernst & Young for its alleged role in the collapse of Lehman Brothers, saying the Big Four accounting firm stood by while the investment bank misled investors about its financial health, people familiar with the matter said.

State Attorney General Andrew Cuomo is close to filing the case, which would mark the first time a major accounting firm was targeted for its role in the financial crisis. The suit stems from transactions Lehman allegedly carried out to make its risk appear lower than it actually was.

Lehman Brothers was long one of Ernst & Young’s biggest clients, and the accounting firm earned approximately $100 million in fees for its auditing work from 2001 through 2008, say people familiar with the matter.

By law publicly held companies must be audited by outside auditors. As would seem obvious the auditors are paid by the companies being audited for this service. This creates an irreconcilable conflict of interests.

Once upon a time people spoke of the Big Five Accounting Firms. When the largest of these firms, Arthur Andersen, collapsed as a consequence of its criminal fraud conviction following the revelation that Enron had been cooking its books, the Big Five became the Big Four.

The purpose of the audit is to instill confidence in the veracity of publicly held companies’ financial statements. It ain’t working.

There’s no reason to think MBIA Inc. and Bank of America Corp. are conspiring to make the Big Four accounting firm PricewaterhouseCoopers LLP look foolish. They couldn’t have done a better job, though, if they tried.

As the outside auditor for both companies, it’s PwC’s job to make sure each presents its financial results fairly. The strange part here is that MBIA and Bank of America have taken dueling accounting positions when it comes to some soured mortgage bonds that MBIA insured during the housing boom. PwC meanwhile is letting both companies’ approaches stand.

From jp’s link: “Investors can only hope that the left hand at PwC will look into what the right hand is blessing.”

That’s flat damned wrong, and Weil should (and does) know better. This is sensationalist journalism. By its nature, the accounting service has “Chinese Walls,” and also by its nature GAAP is a subjective thing, especially when its not the simple stuff like revenue recognition or depreciation rules. For the left and right hand of PwC to talk would be a breach of fiduciary duty. This is just a convenient embarrassment story. Weil, and anyone who cottons to his thinking, should be ashamed.

As for this:

“As would seem obvious the auditors are paid by the companies being audited for this service. This creates an irreconcilable conflict of interests.”

This is absolutely true, but what does one propose? This is no different than a doctor prescribing, an investment counselor prescribing etc.

“The purpose of the audit is to instill confidence in the veracity of publicly held companies’ financial statements. It ain’t working.”

Really? In my profession one understands that a Big 4 stamp doesn’t mean its right, just that GAAP, as best interpreted by the audit team, has been followed. There are no certainties. That concept is fool’s gold.

For years (until it became too expensive) our M&A advice was Deloitte, as were the portfolio companies. But the truth was that over time the M&A advice was Deloitte, and the company audits were “D’Lite.” Hence, we got a divorce.

“My preferred solution would be to drop the requirement. Caveat emptor.”

I agree, although I think any sophisticated person already has adopted this view.

“The situation is similar to the issue with the rating companies. The requirement is an enormous subsidy to a tiny handful of companies.”

Perhaps, but I think your view is overwrought. Your assumption of an “enormous subsidy” is contingent upon the notion of an absolute belief in their work product, a belief I do not think exists, at least among sophisticated and honest people. Rather, there is a belief that their work product is superior to, say, the local Dewey, Fleecem and Howe. That’s all.

I was taught by a work of comedy (the 8o’s “MBA Handbook”) to count the paragraphs in an accountant’s statement in your annual report. Two, you were OK. Three, you were in trouble (read the middle one).

I was at my first job, with a medical company, and imagine my shock when the annual report came out with three paragraphs, the middle one of which said, if your read it carefully, “we didn’t actually see the books.” That was an early illustration for me.

So yeah, I get the idea that each company could make assurances of valuation to their accountant which is at odds with the other, and the accountant’s role is only to log and note the assurance.

Just the same, that whole thing can be a bit of a fig leaf. And Weil can have some fun with that.

I suspect the prosecution will have some fun with it. They will probably call the left hand to testify against the right hand. The left hand clearly isn’t supposed to be looking at the data the right hand is examining, but as to the question of what standards are being used, the other hand is going to be an incriminating voice if they employed different standards.

Drew is probably right that there is no different standard, the auditors are just rubberstamping whatever their client reports that doesn’t contravene a recognized principal.